A new NBER paper by a Dream Team of economists documents the wisdom of short selling crowds. Here is their abstract:
“We study the predictive power of approximately 2.5 million stock picks submitted by individual users to the “CAPS” website run by the Motley Fool company (www.caps.fool.com). These picks prove to be surprisingly informative about future stock prices. Indeed, a strategy of shorting stocks with a disproportionate number of negative picks on the site and buying stocks with a disproportionate number of positive picks produces a return of over nine percent per annum over the sample period. These results are mostly driven by the fact that negative picks on the site strongly predict future stock price declines; positive picks on the site produce returns that are statistically indistinguishable from the market.”
Some nations in Europe are considering banning short sales. Price discovery is an important function of asset prices. In the case of recent housing price dynamics, real estate experts agree that optimists were able to signal their beliefs (by buying) while pessimists were not able to short housing. I know that Mark K. did sell his house but he couldn’t sell 10,000 homes. If there were thick futures markets in trading the Case-Shiller index, then optimists would see that some bets disagree with their expectations and “rational optimists” would think twice before placing their own big bet on rising asset values.